Of Idols and Crises

Here's a quote of the day, perhaps the best metaphor I've heard for where we are now in this financial and economic crisis, a few years downstream of the initial fractures, as authorities (and bankers) in Europe are still trying to duck necessary pain and loss through clever financial slight of hand. From novelist John Lanchester, quoted in Business & Finance:

"It's like there was a giant rumbling noise, the foundations shook, there was a crack in the altar and the golden idol fell down," he says. "And then there was a silence as they picked up the idol, polished it and put it back on the altar and now they're hoping that nobody had noticed. The fact is, we've had three or four supposedly unprecedented crises in the last couple of decades, and these events seem to be getting bigger and more frequent. That suggests to me that we really need to fix the whole architecture of world capitalism, but nothing I've heard suggests that anybody's doing that." 

Truly, nobody is doing that. For the moment, in Greece, in the US, and elsewhere, everything is patchwork, a few small repairs, even the illusion of repairs, and that's it.

How to erase memories

I'm not sure how much relevance this new bit of research has for finance and economics -- quite a lot, I suspect, given the social nature of interpersonal influences, which certainly affect economic outcomes -- but its conclusion is quite striking regardless. Our memories: they can be easily erased or manipulated by social influence, by people around us simply telling us outright lies (or their own false recollections).

Most of us, often, suffer from the illusion that our memories are fairly accurate, especially of things we've experienced first hand. Remember that huge football or baseball game your favourite team won or lost 10 years ago? Remember who made the biggest play? Our memories of these things aren't nearly as good as we think. Countless studies have shown that eyewitnesses are notoriously poor at remembering key facts accurately. A few years ago I got hold of an old recording of a Washington Redskins Superbowl victory from 20 years ago -- the details of which I thought were etched with prefect accuracy in my brain. I was stunned on watching to find out that I had mis-remembered who had made big plays, where they were on the field, when in the game the plays happened, and so on.

What happens in remembering sporting events happens in remembering the rest of our lives too, I'm afraid, and this new set of experiments shows just how easily our memories can be altered by the social influence of people around us. The paper is very well written and doesn't need much explanation. Micah Edelson and colleagues from the Weizmann Institute of Science in Israel had volunteers watch an eyewitness documentary, and then several days later tested their ability to recall facts without any interference, or after being presented with memories as recounted by some other individuals. From their abstract:

We examined how socially induced memory errors are generated in the brain by studying the memory of individuals exposed to recollections of others. Participants exhibited a strong tendency to conform to erroneous recollections of the group, producing both long-lasting and temporary errors, even when their initial memory was strong and accurate.

More profoundly, the study went on, using functional brain imaging, to look at the sites in the brain where these memory changes took place. The volunteers weren't merely reporting something they didn't actually remember just to fit in; their brains actually changed under social pressure, so they remembered something different.

This reminds me of another fascinating result from a few years ago in experiments run by a team led by Gregory Berns of Emory University, who re-examined the famous 1950s experiments on social conformity of Solomon Asch. Berns and colleagues did the experiment in such a way that they could tell that conforming volunteers -- who were effectively discarding their own observations in favor of those reported by others -- weren't just trying to fit in. Social pressure actually made them see the world differently, and specific mechanisms in the brain made it happen.   

As Edelson and colleagues note, this new effect has long been discussed in the social psychology literature and is known as "memory conformity" -- our memories, like other aspects of our behaviour, conform to social pressure. As I said, I don't know immediately how this fits into economics and finance, but it must have some pretty important consequences. Conformity is certainly one mechanism by which all manner of social trends get started, amplified and perpetuated.

As a British friend of mine told me in 2005 -- having just taken out a mortgage on a third speculative property purchase -- "housing prices never go down".  I don't think he had done any independent research to establish this as fact. But he had been reading and listening to the prevailing atmosphere of ideas -- and his brain had been physically altered as a result.

Making markets (appear) safe -- through more vigorous lobbying

It's as predictable as the Sun rising not long after it sets -- financial firms rightly criticized for creating dangerous systemic risks will do what is natural to protect their turf. No, not by looking deeply at their practices and asking if they actually do create greater risk, but by hiring a slew of lobbyists and image consultants to change the debate and stop any potential regulation in its tracks. As this article in the New York Times describes, now it's the turn of the high-frequency traders to follow this time-honored path (thanks to Alex Bentley at the University of Durham, UK for pointing me to this).

I learned last year that writing about finance isn't like writing about science, which I've been doing for 15 years. Scientists get touchy if you criticize their work, but generally respond with reasons and try to convince you you're wrong. Financial firms respond with threats of lawsuits. I found this out last year when I wrote this article for Wired UK on high-frequency trading and its potential systemic perils. I sent an early draft to the then PR person for GETCO, one big HFT firm, asking for her comments and help so I didn't misrepresent anything. I often find that showing interested parties early drafts of articles gets them to voice their criticisms early, so I can take them into account in later drafts. In this case it didn't work, as the PR person didn't respond with any reasoned argument.. Instead, she went quite ballistic. Even though I hadn't criticized GETCO at all in the piece -- I merely mentioned them as HFT traders, and argued that HFT trading in general may present new kinds of systemic risks -- she threatened to get the lawyers involved if I mentioned GETCO in the article at all.

GETCO is one of the firms mentioned in the NYT article as now hiring lots of lobbyists to prevent any new legislation which might hurt their profits, to hell with the stability of markets as a whole.

To be clear, I don't think these people are evil in any sense. They're trading in a legal way, and what they do brings some clear benefits to markets -- it has lowered spreads over the past decade and has indeed made it possible for many smaller traders to compete with the larger banks. But the HFT traders ought to be honest about that fact that no one -- absolutely no one -- currently knows what kinds of new systemic risks enter a market when it becomes dominated by algorithms making thousands of trades a second. This is new territory, and human intuition just isn't up working out what is likely to happen. Paul Wilmott made this point quite eloquently in an NYT OpEd well before the Flash Crash of 6 May, 2010 proved his concerns to be valid.

Since then, as I've mentioned before, we've had lots of smaller flash crashes, and a really devastating one may strike any day and possibly bring deep damage to the larger economy. Personally, it would seem sensible to put in place a speed limit of one trade per second and be done with it. Do we really need to trade faster than that?

Stress tests?

I suspect that what goes on at the European Banking Authority is pretty much above board, in general, but still -- are the stress tests reported on here really designed to find points of potential weakness? I'm not reassured when the New York Times reports that the tests were designed in part to "restore confidence in the overall health of the European financial system." This sounds a little like a public relations angle.

Later, the article gets to the real issue: are these stress tests designed to test the banks against realistically severe scenarios, or instead to throw up some soft balls to be hit hardly so as to restore (misplaced) confidence? Kudos to the writer for including this illuminating quote:

“This year’s tests still did not include the impact of a formal debt default by a European government, which is the single greatest risk facing the European banking sector at present,” Marie Diron, an economist who advises the consulting firm Ernst & Young, wrote in a note. “The publication of these results will not assuage investors’ fears over the resilience of the E.U. banking sector,” she wrote, referring to the European Union.   

Leverage control for market stability

I listened today to a number of extremely informative talks at a workshop in Durham (UK) on Tipping Points in Financial Systems (description here part way down the page). I'll make some comments on the various talks in coming days. But it might be worth noting a few observations on some further progress on a model of market volatility -- and its inherent link to leverage -- achieved by Stefan Thurner and colleagues.

I wrote about this work several years ago in an OpEd for the New York Times, and also in this thing for Nature, but today learned about some further developments which seem particularly important. The model developed in this work makes the point that saavy participants in speculative markets (call them "hedge funds," but they could banks or just one individual) can use leverage to deliver higher returns and thereby attract more investors. This is obvious and natural. Many details aside, however, the model showed that the competition between funds to attract investors drives a race to higher leverage, increasing market volatility, and the eventual probability of violent market crashes. Leverage is dangerous and comes with systemic costs.

This can be seen (in an abstract way, sorry) from the figure below from the paper. In a long simulation of the market, this shows that the likelihood of finding market returns (absolute value of the logarithm of prices differences over a short time) exceeding a value R. The red is how the market works when leverage is low -- the probability to see really big market movements, R > 0.1 or so, is extremely small. But as hedge funds evolve to use significant leverage, the market moves into a regime described instead by the blue curve -- the probability of tail events and extreme movements becomes orders of magnitude larger.

The implication is clear: leverage causes volatility.

But Thurner suggested today that intermediate levels of leverage actually reduce market volatility, because it makes it easier for the saavy hedge fund investors to pounce on and wipe out market mispricings. This is an interesting point and one worth pondering. I haven't yet digested the latter parts of the updated paper, which now considers several policy moves and how they influence volatility, but the results have the wonderful ambiguity that one learns to expect in confronting complex systems. For example, capping leverage at intermediate levels (factors of around 10) is in some case worse than capping it at higher levels (around 15). Controls on the capital reserves held by the funds (or banks) also have some ambiguous results -- in some cases, making them hold higher reserves can lead to more volatility in the market, not less. Weird.

I'll try to digest this new work and report on it's implications once I understand them more clearly, but they already demonstrate the point that our intuition isn't so good at seeing the link between interventions in markets and the likely consequences. I'm certainly guilty on occasion of thinking that if the financial industry is against any proposed regulation, then it must be a good one. Often that's not a bad rule of thumb. But if we're really going to make progress in making markets work for everyone, we need to think very carefully -- and back up proposals with hard evidence. This work is developing such evidence.

How derivatives make markets unstable: Part I

I posted a while back on some of the dirty secrets of the derivatives industry. I promised then to give a little more discussion at some point of two terrifically important pieces of research -- still not widely known, especially in mainstream finance -- which show how adding more derivatives to a market can make it less stable, not more stable. This goes directly against the received wisdom of economic (equilibrium) theory which claims that markets become more efficient as they become more complete, i.e. as it becomes possible to take essentially any kind of market position by virtue of a dense spectrum of financial instruments.

One of the papers I had in mind was this landmark study from several years ago in which William Brock, Cars Hommes and Florian Wagener considered the question of whether, in the run up to the recent crisis, "... highly leveraged positions using complex financial instruments may have amplified market volatility." The answer to which their analysis leads is -- yes, quite probably. More generally, they illustrate how more derivatives in general should make markets more unstable, increasing volatility.

Their paper is a little technical, but worth a read. I'll outline the gist of their argument, which starts with several straightforward observations and moves to a not-so-obvious conclusion:

Observation 1: They start by noting that people aren't the hyper-rational automatons of Milton Friedman's (or other neo-classical economists') favorite fantasies. Rather, people in the real world form their expectations and craft their behaviour in an adaptive way -- that is, they learn from experience.

Observation 2: They also note that people aren't identical. We not only learn, but our brains are different and we've all had different experiences in the past, so, at any moment, we've probably learned different things and have slightly different expectations (heterogeneous expectations, in economic lingo) about the future.

Observation 3: People are generally risk averse -- if they're willing to bet $100 on a gamble that could pay off, but involves risks, they'll be willing to bet more than $100 in the same gamble if you reduce the risks. In other words, people shy away from gambles more the riskier they are. This is basic empirical psychology.

Starting from these observations, Brock and colleagues then consider an "intertemporal" asset market (economist-speak meaning a market in which time exists) in which a lot of people look to past prices and try to predict future prices, buying and selling as they see fit. This market contains both risky and non-risky things to invest in -- stocks and risk-free bonds (which are guaranteed to increase in value by a factor R>1 over each interval of time). Stocks might rise more, but are less certain and hence riskier. In addition, the people can buy derivatives -- instruments which act like pure bets and give a pay off in certain circumstances.

What this all amounts to is that people in this market can 1) play it safe by buying bonds, 2) gamble more by buying stocks, and also 3) buy derivatives if they want which (in this model) have no effect except to offset some of the risks involved in buying stocks.

What Brock and colleagues then show is that the combination of the derivatives, the risk aversion of investors, and their tendency to learn by "reinforcement" -- to be more likely to follow strategies which have paid off in the past -- leads directly to trouble. I'll describe how in a moment, but one final thing before I do: the strength of reinforcement learning in the model (how quickly people shift to use better performing strategies) is controlled by one parameter β; bigger β means faster switching. In previous work, Brock and Hommes have shown that in an asset market in which people learn by the reinforcement process, there is a natural "tipping point" -- at a certain critical value of β -- where the market goes from being stable to being unstable. Intuitively, when people switch too quickly, taking even scanty short term evidence as proof of a strategy's superiority, fluctuations in the market become much stronger.

OK, so what happens in this market when you currently have, say, 15 possible derivatives covering lots of different possible outcomes, and now add a 16th derivative to cover other outcomes (i.e. we have derivatives on stocks and commodities, and suddenly invent some new ones to cover mortgage bonds)? Brock and colleagues show that the addition of this one new derivative makes the market go unstable more quickly, i.e. at a lower value of β. The mechanism involves a simple interplay of reduced risk and human confidence. This new derivative, by making it possible for investors to lower the risks associated with investments, leads them to invest more money. They take bigger bets. These bigger bets naturally amplify how quickly the bets that turn out to be correct amass profits. So, there are bigger differences in the payoffs to recent winning and losing strategies, which draws more followers to the winners more quickly (even if the fundamental switching rate of people haven't changed).

In brief: by the very act of reducing the risk of some strategies, the derivative invites more vigorous gambling on that strategy, leading to faster flows of people from one strategy to another. The extra derivative makes the market more volatile.

This model doesn't involve many questionable assumptions. It's a very basic model of the most central facts of any market, respecting some realities of human psychology. It suggests that derivatives hold inherent dangers. Yet as far as I can see, the ongoing discussion of regulating derivatives isn't taking this perspective into account. As Satyajit Das notes, the drive toward greater returns that is an essential part of the dynamics in the Brock, Hommes and Wagener model is a very real force in today's derivatives markets:

Investors searching for return drive speculation. Concerned about stagnant real incomes and inadequate retirement savings, individual investors seek out higher yielding investment structures, often based on derivatives. Pension funds and other institutional investors use derivatives to enhance returns to fully fund and meet their contracted liabilities. In an environment of diminishing returns and fierce competition for attractive investments, fund managers use derivative strategies to enhance returns through readily accessible leverage and capacity to create risk “cocktails”.

Facing increased pressure on earnings, corporations have increasingly “financialised”, resorting to speculative derivative trading to meet profit expectations. ... [Such] seculative activity amplifies rather than reduces volatility and systemic risks. Perversely, this may impede capital formation and also increase the cost of capital for companies.

What happens in the real world backs up the lesson of this simple model. Derivatives reduce risks only in a very narrow and restricted sense, while undermining the functioning of markets more generally. Of course, there's lots of money to be made by the people selling derivatives, so don't expect them to admit (or care about) any of this.

Bank runs begin in Greece and Ireland

Gavyn Davies refers to the image below, which presents a rather disturbing trend in bank deposits in Greece and Ireland. Notably, banks in these two countries in the past year or two have experienced a sharp increase in withdrawals of retail deposits:

Davies suggests they've lost 15% of their deposits, but it could be significantly worse than that -- note that the data in the figure only goes up to around December 2010. Extrapolate the trend through to today and I'm guessing the loss is approaching 30-35%.

Fully one third of the retails deposits in these two nations have been pulled out?! Yikes. Not a good sign. As Davies comments:

As the UK government found in the case of Northern Rock, the appearance of queues outside banks is one of the worst nightmares which a central bank can face. It has not happened in Europe – yet.